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Investing -- Part V
Investing for your future is always a key part of any sound financial management program, but as a new parent the need may be even greater. As we've discussed, you will have all sorts of unforeseen expenses both in the short and long term. Investing wisely is one of the best ways to get your dollars working for you now so that they can provide the financial security you need for your family later.
It's important to understand that although making a quick profit is an exciting part of investing, having an understanding of the basics is key to building a long-term strategy. There are many types of investment options to pick from - with all of the possibilities, there is certainly one that is right for you. Keep in mind that the investment world is vast and you're well served in doing your homework - thoroughly. In this section, we will cover:
Keep in mind that the investment world is a vast one and you'd be well served
in doing your homework -- thoroughly.
Risk vs. Return
Investment vehicles vary in terms of risk, from the safer money market securities to the highly volatile futures and commodity offerings. In general, the amount of risk investors take will correspond with the return they can potentially earn. In other words, high risk generally correlates with high return and lower risk with lower return. Where an investor's portfolio falls on the risk spectrum should reflect the particular investor's:
- Long term goals
- Immediate need for money
- Age
- Risk tolerance
Historically, women have proven to be less risky than men, so their investment portfolios have provided them with lower overall returns. Investing should not be considered a gamble - with careful planning it is possible to both manage your risk and make money.
Stocks
When most people think of investing, the first thing that comes to mind is buying a stock. A share of stock, or equity, reflects a share of ownership in a company. For example, if XYZ company has 100 shares outstanding and you own 5 shares, you own 5% of the company.
The price of a company's stock reflects the company's current worth and how investors expect the company to do in the future. The price an investor pays for a share of a widely-held company is set by the millions of buyers and sellers in the market. The price is set at the dollar amount where buyers won't pay a higher price and sellers won't accept a lower one. The price fluctuations of a company's stock reflect the success of the company, the industry and the overall economy. Since corporate growth drives economic growth, there is a direct relationship between stock market performance and economic growth. Stock prices are also affected by changes in inflation, risk and the level of interest rates.
Mutual Funds
A mutual fund company pools money from many investors and purchases different securities on their behalf. Proportionate to the size of their investments, investors share in the investment gains and losses produced by the fund. Each mutual fund has an investment manager, or investment adviser, who manages the fund to meet its investment objectives as described in that particular fund's prospectus.
There are several key attributes that make mutual funds extremely popular among individual investors in the United States.
- Diversification: A single fund may hold securities from hundreds of different issuers -- something few investors could accomplish on their own. This broad diversification significantly reduces downside risk caused by problems with an individual stock or bond.
- Professional Management: A seasoned investment manager who has access to extensive research, market information, skilled analysts and traders and technology makes investment decisions for the fund. Few individual investors have the time or dedication to select securities and closely track the portfolios.
- Liquidity: Shares in a mutual fund may be bought and sold on any business day in the United States. A fund is required to redeem shares for the market value of the securities within the fund.
- Convenience: Funds may be purchased or sold by mail, telephone, or via the Internet and monies can be transferred from one fund to another to reflect an investor's changing views or needs.
- Small initial investment: Many funds offer minimum initial investments of less than $1000 and increments of $100 or less.
Bonds
A bond is an agreement between the lender (investor) and the borrower (issuer). In return for up-front cash, the issuer promises to make specific payments to the bondholder on specific dates. Consequently, the bond investors can expect fixed payments, as well as the principle repayment at maturity.
Bonds can be issued by governments, agencies, municipalities, or corporations. Their overall risk and return depend on the credit worthiness of the issuing institution. Bonds have a defined maturity, or end date, and can have a fixed or variable rate of interest that dictates the bond's interest (coupon payments). Fixed rates remain the same through the life of the bond, whereas variable rates fluctuate with changes in interest rates.
Be aware that, depending on the maturity or callability of a bond, the value at maturity may not have kept up with inflation, i.e. though you get your principle back, it may be worth far less in current dollars than at the time purchased. In this instance, you are dealing with a different type of risk...the reduced value of the principle. It is imperative to balance the return ON the investment with the return OF the investment.
Bonds have several attributes that make them an attractive investment. First of all, a holder of bonds can usually expect to receive income from regular interest payments, made either semiannually or annually, depending on the bond. Additionally, the borrower (issuer of the bond) is obligated to return the principle at the end of the term of the bond. Because of these fixed obligations, buying bonds is often perceived as less risky than investing in stocks.
On the negative side, bonds can lose value when inflation is high. Because the bond's interest rate is usually not tied to inflation, the inflation can often erode your return. Also, investors should be weary of investing in bonds when interest rates are low because locking in a low rate today can prevent the investor from reaping a higher income should interest rates rise.
International Investing
With all the different equity markets in the world (Canada, UK, Tokyo, Hong Kong, just to name a few) investors that do not explore overseas investment opportunities might be missing out on superior returns. Not all markets move in the same direction at the same time so it stands to reason that a portfolio made up of globally diversified stocks will remain more stable than a single country stock portfolio over time.
Correlation refers to how two investments move relative to each other. For example, if when Stock XYZ goes up by 5% Stock ABC also rises by 5%, the two securities are perfectly positively correlated. Had they moved by the same percentage in opposite directions, they would be perfectly negatively correlated. Now, if they move in the same direction but by different percentages, they are considered positively correlated. If, on the other hand, they move in opposite directions, they are deemed negatively correlated. The less the correlation between securities in your portfolio, the more risk you can diversify away. If you hold a portfolio of risky securities that have low correlations with each other you should benefit from diversification which can eliminate most country specific risk from your portfolio.
For the sophisticated investor
Investing reaches far beyond basic stocks, mutual funds and bonds. There are many complex investment products designed to suit the needs and wants of more sophisticated investors. From options and futures to commodities and hedge funds, savvy investors attempt to maximize their earnings potential with a myriad of financial instruments.
Keep in mind that although these vehicles might increase your profit potential, they can also expose you to higher risk. Be sure to assess your own risk tolerance and needs before investing in any of these products.
Continue to:
Part VI: Estate Planning
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